Conference on Derivatives Markets for Viet Nam Framework Presentation

What systemic protections are envisioned to prevent manipulation of the market for theunderlying asset and/or the derivatives market6. Cash-Settled Reduces the market disruption risk be

Conference on Derivatives Markets for Viet Nam

Framework Presentation

Robert H Singletary

VIE-026

The State Securities Commission of Viet Nam isconducting a program to support the creation of aderivatives market for the country.

This Conference is designed to engage industry andinternational specialists to share the SSC’s progress todate and gather information to better guide theCommission’s policy and regulatory decisions

Introduction

1 What is the industry demand for derivatives?

2 Should the SSC’s goal be to develop standardized

derivatives or tailored derivatives (OTC derivatives), or both?

3 What type of derivatives should be developed?

(options / futures) (cash-settled / physically delivered)

The Threshold Questions

4 What types of underlying assets will be allowed?

5 Which securities should be the underlying asset?

6 Who will be the infrastructure institutions:

Trading mechanismsIntermediaries

Purchasers and sellersClearance and settlement

The Threshold Questions (continued)

7 What systemic protections are envisioned for

default by purchasers and sellers?

8 What systemic protections are envisioned to

prevent manipulation of the market for theunderlying asset and/or the derivatives market?

The Threshold Questions (continued)

The Answers to these Threshold Questions Will Drive the

Architectural Choices for the Derivatives Markets

1 What does the industry want (need)?

The SSC, in its role as market designer, wants to

understand what this market needs today, and what

the needs may be over the near-term horizon

However, systemic safeguards and investor protections must be built in

View: The derivatives market architecture and products

should be “demand-driven”

2 Standardized, OTC derivatives or both?

2 Standardized, OTC derivatives or both?

In-Country OTC Derivatives Practices Today

1 VN has an OTC forwards market already

2 The maturities are short

3 The underlying assets are bonds or currency

4 This is an institutional investor market

Preliminary View: The SSC should not attempt to force the institutional OTC activity onto a standardized, organized market

Economic Outcomes for Futures and Options Holders

3 What types of derivatives?

Expiration Market Price

3 What types of derivatives?

Standardized Futures Contracts

Present more systemic risk (default risk) because both parties are compelled to perform on expiration date

Standardized Options Contracts

Present less systemic risk (default risk) because the

parties must perform only if the price movement is

favorable to the holder Otherwise , the option expires worthless

3 What types of derivatives?

Cash-Settled

Reduces the market disruption risk because the

delivering party does not need to deliver the

underlying asset itself Cash is paid

Physically Delivered

Exposes the market to disruption risk because the

delivering party needs to deliver the actual underlying asset

3 What types of derivatives?

Does industry have strong, specific needs for a certain

type of derivative for each underlying market – i.e., habit

and/or expectation?

Preliminary View: No decision yet between Futures or Options

Preliminary View: There is a preference to develop

cash-settled derivatives first

4 What types of underlying assets will be allowed?

In theory, there are numerous types of assets that could have derivatives traded over them

Currency

Gold

Interest Rates

Stock IndicesGovernment BondsCorporate BondsStocks

RubberCashewsCoffee

4 What types of underlying assets will be allowed?

Assets / Jurisdiction

Information flow from underlying market

Jurisdiction over underlying market

Jurisdiction over derivatives market

Derivative is a security?

4 What types of underlying assets will be allowed?

Ministry of Finance (Art (6)(1)(d))

In the intermediate term Viet Nam should address how

to trade derivatives on commodities in a manner compatible with trading derivatives on financial assets

5 Which securities should be the underlying asset?

What should be the criteria for selecting the underlying securities?

Market demandLiquidity of trading in the underlying assetInformation flow from trading in the underlying asset and possible IT linkages

Thin or shallow trading in the underlying asset exposes the system to:

Market manipulation of the underlying assetMarket disruption in the underlying asset (for physically delivered assets)

Erratic pricing for the derivative

View: The Commission should only allow derivatives

trading over the deepest traded securities

5 Which securities should be the underlying asset?

The Trading Market for Derivatives

6 Who will be the infrastructure institutions Exchanges?

Intermediaries

Trading Mechanism

Retail

Investors

Sellers Buyers

Clearance and Settlement

Market for the Derivative

Investors

Intermediaries

Trading Mechanism

CCP Clearance and Settlement

Sellers Buyers

Market for the Underlying Asset

Trading Mechanism

Clearance and Settlement

Sellers Buyers Investors

Pricing

6 Who will be the infrastructure institutions Exchanges?

Information flow and IT linkages are necessary to allow:

Efficient pricing of the derivativesMarket surveillance

Will the same exchange that trades the underlying asset

be allowed to trade the derivative on it?

What happens when the underlying asset is traded

off-exchange?

6 Who will be the infrastructure institutions Exchanges?

Preliminary View: Side-by-Side trading should be allowed first Cross trading will depend on IT linkages and

surveillance issues

View: Trading of derivatives on assets that are trade

off-exchange should not be allowed

6 Who will be the infrastructure institutions Exchanges?

6 Who will be the infrastructure institutions Intermediaries?

Intermediaries:

Will all licensed securities companies be allowed to

intermediate? (Issues of expertise and capital)

Preliminary View: Because SCs should be required to

stand behind the trades of their clients, only those with sufficient capital should be authorized

Purchasers and sellers:

Will purchasers / sellers be limited to VN entities only? What is the impact of the foreign ownership

Preliminary View: The use of cash-settled derivativessolves the foreign ownership limit problem Also true forderivatives on indices or ETFs that contain stocks thathave reached the ownership limit.

Preliminary View: Physically delivered derivatives can beused for debt instruments

Preliminary View: Participation in the derivativesmarkets should not be limited

6 Who will be the infrastructure institutions – Purchasers and Sellers?

Clearance and Settlement:

Will the system contain a “central counterparty”?

Will there be a default guarantee fund?

Will the securities companies be required to guarantee the performance of their customers?

6 Who will be the infrastructure institutions – Clearance and Settlement?

Clearance and Settlement:

Who will record position ownership?

Will this be a 2 tier or 1 tier record-keeping system?Who has the expertise, operational capacity a risk management systems to serve this function?

6 Who will be the infrastructure institutions – Clearance and Settlement?

View: VN should use a Central Counterparty

View: VN should use a guarantee fund

View: Securities companies should be required to stand behind the trades of their customers

Preliminary View: A 1-tier system (where the CCP can

see the customer who holds the position) is preferable

7 What protections are envisioned for default risk?

7 What protections are envisioned for default risk?

Default risk protections:

“Margin” deposits (pre-pay and/or pre-deliver in full adversely affects the economics of derivatives)Securities company guarantees (this impacts capital requirements)

Guarantee fund (must be used as last resort, not as

“slush fund”

Market for the Derivative

Investors

Securities Companies

Exchange Central

Counterparty

Sellers Buyers

Market for the Underlying Security

Sellers Buyers Investors

Pricing

8 What protections are envisioned for market manipulation?

Preliminary View: VN should use position limits.

Preliminary View: VN should use exercise limits

Preliminary View: VN should only allow derivatives on

exchange traded assets

8 What protections are envisioned for market manipulation?

Summary of Threshold Decisions

1 Determining industry demand and the ability of the

design to meet it

2 Choosing Standardized, OTC, or both

3 Determining options versus futures, cash-settled versus

physical delivery (and perhaps differentiating between underlying asset)

4 Determining the eligible underlying assets

Conclusions

Summary of Threshold Decisions (continued)

5 Determining eligibility criteria for intermediaries

6 Selecting trading mechanisms

7 Determining whether there shall be a central

counterparty and record-keeping system

8 Determining protections against default risk

9 Determining protections against market manipulation

Conclusions